Machine Learning in Finance
ISB presentation
Claudio Moni
25/03/2010
Main applications
• Forecasting financial time series to identify
trading opportunities.
• Estimating assets distributions, for trading and
risk-management.
• Derivatives pricing (small)
Forecasting
• Difficult!
• High level of noise in financial time series.
• Suppose we want to estimate the equity
market (annualised) return, which is of the
order of 5%, with a +-5% confidence interval.
How many years of daily data do we need,
assuming historical volatility is 20%? 64 years!
• Situation improves at high frequencies, as
more data are available.
Forecasting
• Difficult!
• High level of noise in financial time series.
• Suppose we want to estimate the equity
market (annualised) return, which is of the
order of 5%, with a +-5% confidence interval.
How many years of daily data do we need,
assuming historical volatility is 20%? 64 years!
• Situation improves at high frequencies, as
more data are available.
Forecasting
• Difficult!
• High level of noise in financial time series.
• Suppose we want to estimate the equity
market (annualised) return, which is of the
order of 5%, with a +-5% confidence interval.
How many years of daily data do we need,
assuming historical volatility is 20%? 64 years!
• Situation improves at high frequencies, as
more data are available.
Forecasting 2
• Financial time series are non-stationary.
• Business cycles.
• Small disjuncts alternative.
• We can try to forecast an asset in isolation or
a set of interrelated assets all.
Regression vs. Classification
• Financial forecasting is (usually) a regression
problem.
• It is not enough to know that the expected return
from a financial bet is positive to decide to make
it and to decide how much to bet.
• It makes financial sense to invest more in the
most profitable opportunities (see Kelly criterion)
• This applies to a single strategy across time, or
when the strategy is part of a portfolio.
Technical Analysis
• Set of standard trading rules, mainly based on
graphical patterns.
• No theoretical justification.
• Usually not thoroughly back-tested.
• Can become self-fulfilling prophecies.
• TA rules are often used as building blocks for
Machine Learning systems.
TA Example: 2 crossing moving averages
signalling the beginning of a trend.
Empirical approach
• Instead of estimating the dynamics of the
underlying processes and then construct
strategies exploiting these dynamics, estimate
the trading strategies directly.
• Metric: trading performance, usually
measured by the Sharpe ratio = mean/stdev.
• Robust with respect to process misspecification.
Quantization
• Often useful to turn a continuous process into
a discrete one.
• Subdivide R into a set of intervals, user
defined or obtained by clustering.
• Limit case for returns: {Ret<0, Ret>=0}.
• Reduces noise but throws away information.
• Allows Markov chains models to be used.
Markov Chain Models
• Markov chain of order L:
Pt 1 ( X (t )  xi )  P( X (t )  xi |{ X (t  j )  xi ( j ) } j 1:L ).
• Probabilities can be estimated from historical
frequencies:
P  X (t )  xi |{ X (t  j )  xi ( j ) } j 1:L  
P  ( xi ( L ) , xi ( L 1) ,..., xi (1) , xi ) 
P  ( xi ( L ) , xi ( L 1) ,..., xi (1) ) 
• If L is large, the historical probabilities could
be smoothed by K-NN or other methods.
.
Evolutionary approaches
• The empirical strategy selection can be very
naturally generated through evolution.
• Fitness: trading performance.
• Mutation: small parameter changes.
• Crossover: combination of parts of different
strategies. For example
(S1,S2) = [A*and(B,C), D*and(E,F)] ->
(S3,S4) = [A*and(B,F), D*and(E,C)].
Neural Networks
• Non-linear regression.
• The independent variables can be given by the
underlying process (e.g. daily returns), or
more commonly by a set of trading signals
generated by user defined trading rules.
• Has been found to generate positive trading
results, although not necessarily better than
those obtained by using simpler models.
News mining
• News are part of the information available to
human traders.
• Machines need to be able to use this source of
information too.
• Natural Language Processing.
• News classification, Bag of words, SVM.
• Useful to human traders too, to filter incoming
news by relevance.
Reinforcement Learning
• Can be used for game-theoretic problems.
• Optimal trade execution, to minimize market
impact.
• Often large numbers of shares need to be
bought (or sold), and the trade has to be split
in a number of smaller trades since not
enough shares are for sale at a given moment
in time, or not a good price. Need to hide our
intentions to prevent price from rising.
Estimating assets distributions
• Standard statistical techniques.
• Filtering.
• Dimensionality reduction.
Filtering
• Hidden variable models.
• Example 1: Stochastic volatility models.
• Example 2: Factor models. Some factors may
not be observable or observable only at
discrete times. E.g. Interest rates, inflation,
GDP, ...
• Kalman Filter. Extended KF, Unscented KF.
• Particle Filtering.
Dimensionality reduction
• Example: Interest rate curve. PCA: 3 factors
typically explain 90%-95% of the variance.
Derivatives pricing
• Small area of application for ML since here we
work with risk-neutral probabilities instead of
historical ones.
• One main application: approximation of
American style option by parametric functions
of the state variables, through regression.
• Monte Carlo simulation, Local Least Squares.
Questions?
References
• [AD09] Adamu, K. (2009) Modelling Financial Time Series using
Grammatical Evolution. Talk given at the AMLCF 2009 conference, London.
http://videolectures.net/amlcf09_london/
• [AL10] Aldridge, I. (2010) High Frequency Trading. John Wiley and Sons.
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Trading. Working paper.
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http://videolectures.net/amlcf09_london/
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http://videolectures.net/amlcf09_london/
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